Transition to T+1 Equity Settlement

From 28 May 2024 investors will need to settle US and Canadian equity transactions on a T+1 basis after the US Securities and Exchange Commission (SEC) set this as the deadline to switch over from the current trade plus two-day (T+2) regime. The SEC’s objective is to make markets safer for investors following the meme stock frenzy of 2021¹. It may come as a surprise to some that this represents a return to the settlement cycle that was in place until 1933 so one would imagine that with today’s technology it should be easy to implement, notwithstanding the significantly larger volumes compared with that era. However, for some market participants the move to T+1 will be far from easy.

Source: JP Konig, Moneyness Blog

Challenges and Solutions in the Move to T+1

The move to T+1 creates an issue for investors outside the Americas who need to trade their domestic currencies for USD and CAD to purchase or sell US and Canadian equities. This requires that they synchronise currency and equity settlement schedules. Such synchronisation is challenging because the change in the securities settlement speed leaves FX traders in countries such as Australia, Hong Kong and Singapore with barely any time to match and settle their FX hedges. Back offices in some jurisdictions will have just one or two hours to complete their post-trade settlement processes instead of the full working day they currently have.

If investors cannot synchronise their equity and FX settlement cycles, they will have to consider pre-funding their transactions, which will increase costs and operational complexity, or make more extreme changes to their execution and settlement arrangements.

Making matters worse, Continuous Linked Settlement (CLS) may no longer be available owing to the shorter settlement time. This means investors will need to consider recreating payment versus payment settlement somehow, increasing settlement limits with their existing FX dealers and prime brokers or, if that is not possible, they will need more dealers. Any changes in an investor’s FX execution will have to be balanced against best execution obligations owed to their clients.

Most US equity trades are executed just before the New York close at 16:00 Eastern Time, which is 05:00 in Singapore and Hong Kong, or 08:00 Sydney time. However, FX markets are dormant at the NY close. Investors hedge the FX of these equity trades, basing the notional on the confirmed and matched equity transactions.

Under the T+2 settlement regime, a superfund in Australia might have at least 12 hours to hedge the FX related to their US equity purchases, do post-trade checks and submit the trades to their custodians to send to CLS. This allows them to benefit from the best FX liquidity during European hours, particularly using the WMR fix at 11:00 New York time / 16:00 London time. This keeps transaction costs low and helps ensure best execution obligations are satisfied. In addition, by using CLS the trades will bear no settlement risk. The cut-off time for CLS is midnight CET, but investors must meet earlier deadlines set by their custodians for their trades to be sent to CLS.

Under the T+1 regime the time available to Australian, Singaporean and other regional investors is significantly reduced, particularly if the investor wishes to submit the trade to their custodian in time for it to be sent to CLS. Eastern hemisphere payment systems tend to shut before the WMR benchmark. In terms of UK hours, HKD closes at 1030, AUD and SGD close at 1100 and JPY closes at 1200. This means none of these currencies are deliverable after the benchmark and are certainly not deliverable in US hours (e.g. JPY closes at 0700 EST). It may be the case that the investor must execute their FX in a very narrow window for T+1, or alternatively execute the FX hedge the next day for settlement T+0, although this means that the trade cannot be submitted to CLS. In addition, if a local equity is being sold for a US equity, then this may be for T0 in Asia and T+1 in the US. In other words, the Asian market closes before the US market opens.

There are various options that investors can use to address the move to T+1:

• Set up a trading desk in the US (or a night desk) to trade FX at the US equity close. However, they may struggle for liquidity and best execution in an FX market that is effectively dormant at that time. This is also likely to be expensive.
• Execute their FX hedges for T+0 in Asian hours. This leaves a short period to match, fund and settle considering their local payment systems will be closed by the time New York opens.
• Estimate the notional that needs to be hedged and trade ahead of the actual equity transactions to ensure good execution quality on the FX leg. Then, the following day, once actual amounts are known, trade a second time to adjust the estimate. This is likely to be operationally complex and liable to error.
• Hand over their FX trades to their custodians, although this could limit the ability to achieve best execution by narrowing the number of FX price providers. Additionally, investors may have insufficient FX settlement limits with their custodians, particularly if CLS is not available.

The Stablecoin Alternative

This approach is a hybrid of pre-funding. An investor estimates the necessary USD proceeds to purchase the stocks and buys the corresponding notional amount of eastern hemisphere currency stablecoins. There are stablecoins available for AUD, CNH, JPY, NZD and SGD. Stablecoins are planned for HKD, IDR, MYR and PHP. Unlike fiat currency, stablecoins use blockchain based platforms that are available 24-7. The notion of a same-day cut-off is therefore redundant, allowing for a transaction in a stablecoin to be settled in US hours. In other words, an eastern hemisphere stablecoin can be settled synchronously to the USD that are needed to purchase equities.

In this case, stablecoins purchased and delivered in eastern hours are held into the US business day. The FX hedge using stablecoins can be executed in European hours, say 0900 UK time, for value T0 without the worry that the eastern payment cut-offs are between 1030 and 1200. Investors would still have the rest of the Europe and US Day to settle the FX hedge, delivering stablecoins for USD.

A further consideration, which would recreate CLS, would be to deliver eastern stablecoins for a USD stablecoin. Most cryptoasset custodians and custodial networks offer PvP settlement for a cryptoasset vs cryptoasset trade. So, if a broker and an investor use the same custodian, then the custodian will ensure that the USD stablecoin and the Asian stablecoin are settled at the same time, with one leg contingent on the other. The USD stablecoin can be liquidated for USD in US hours. Excess Asian stablecoins can be sold off for settlement in the following Asian morning.

To use stablecoins, an investor would need to set up a digital asset wallet with a custodian or wallet provider. It would either need to onboard a counterparty that offers FX pricing versus stablecoins or it could onboard the relevant stablecoin issuer(s). It would also need to assess the stablecoins it wished to use and satisfy itself as to the creditworthiness and operational risks presented by using stablecoins.

Ultimately, being able to remove the ticking clock of FX settlement cut off times using stablecoins should provide valuable breathing room for back office teams to adjust to the new T+1 equity settlement regime. It would also anticipate the day when no doubt all asset classes move to a T+0 settlement cycle. As we have seen, the move to T+1 has only returned the market to the settlement timelines in use until 1933. While there are arguments for having a degree of deferred settlement, there are no doubt customers who would prefer T+0 and service industries should be able to provide choice to their clients.

It is also somewhat damning that many eCommerce platforms can deliver physical goods to one’s doorstep T+0 on a weekend, yet an equity trade placed at the same time would not settle until the following Tuesday.

¹ Aggarwal, D; The Meme Stock Frenzy; https://corpgov.law.harvard.edu/2023/05/16/the-meme-stock-frenzy-origins-and-implications/